Oil Prices: Where is it heading? Lessons From Security Analysis

One of the most common topics discussed these days would be where do we see oil heading? I have read countless of articles regarding this topic. Some of the latest estimates would be analysts placing a short-term floor of approximately $35 a barrel, while option traders are placing bets that prices could fall further into the $20 region in the next few months. As a student of value investing, I find the study of economic history to not only be interesting but relevant to today’s world as well. While I will not delve into the relevance of economic history with value investing, I wanted to share a short history of the oil prices over the past 3 decades or so and my take on oil.

History of Crude Oil

Looking at the top 10 oil producing countries, one would realise that a majority of them are actually very unstable countries such as Russia, Saudi Arabia, Iraq, Iran and UAE.

Over the last decade or so, oil prices have been relatively high (>$100) due to the surge in demand for oil in countries like China and conflicts in these unstable yet key oil producing nations. With supply being unable to keep up with growth in demand, it resulted in oil prices spiking.

Going forward, such high oil prices resulted in US and Canada to start drilling in North Dakota and Texas shale formation. This led to an unprecedented surge in supply of oil where the US alone was adding 4million bbl/day of crude oil. This was significant given how global crude production stood at approximately 75million bbl/day. Furthermore, with the slowdown in economies, the demand for oil started declining for US, Eurozone and Asia. Hence, this resulted in the oversupply of oil within the world economy.

This situation would’ve been easily resolved on the OPEC’s part given how the cartel has normally controlled global oil prices by cutting back or boosting oil production. However, with their meeting in Vienna, they decided to keep oil production as it is, allowing the oil prices to continue falling. While many of these countries require the high oil prices to balance their budgets, they decided to run into a budget deficit this time around to engage with a price war with the US shale producers.

Will Oil Prices remain so low?

Having understood the history of oil prices – reasons for the huge fluctuations, the big question still remains, will oil prices still remain so low? While it is very hard to predict where the price floor for oil would be, our personal take is that prices would most likely rebound back in the future. As with history, these top oil producing nations have always been unstable and it is likely that some conflict or turmoil might break out somewhere causing oil productions to decrease or a nation defaulting due to the huge budget deficits incurred during this period. Furthermore, with credit easing in China, we would not know how this would affect their demand for oil in the future. If history is any indication, oil prices should eventually rise back again, just that we are unable to predict when.

Investing in Oil Producers

With the decline in oil prices, we see many oil-related companies having their market capitalisation slashed by 30% or more. However, are these oil producing companies truly dependent on oil prices? Initially, we thought that this was so. On the surface, with the decline in oil prices, it has a negative effect on the revenue of oil producers. With this, we like to point out a paragraph in the book Security Analysis.

The competition for such values is fiercer in the United States, but they can be found, especially, again, when some broader trend punishes an entire sector of the market. In 2001, for instance, energy stocks were cheap (as was the price of oil). Graham and Dodd would not have advised speculating on the price of oil – which is dependent on myriad uncertain factors from OPEC to the growth rate of China’s economy to the weather. But because the industry was depressed, drilling companies were selling for less than the value of their equipment. Ensco International was trading at less than $15 per share, while the replacement value of its rigs was estimated at $35. Patterson-UTI Energy owned some 350 rigs worth about $2.8billion. Yet its stock was trading for only $1billion. Investors were getting the assets at a huge discount. Through the subsequent oil price rise made these stocks home runs, the key point is that the investments weren’t dependent on the oil price. Graham and Dodd investors bought into these stocks with a substantial margin of safety.

Author: SG Value InvestorI developed my passion for investment management especially equity research at a relatively young age. My investment journey began when I was 20, at a point in time where markets were still recovering from the Global Financial Crisis. My portfolio started from money I saved over the past years and through working during the holidays. I was fortunate to have a good friend with common investing mentality to began my journey towards value investing. To date, we still research and invest in companies together, discussing valuations and potential risks of a company.To date, I manage a fund with a value investing style. Positions are decided upon via a bottom-up approach or smart speculation (a term I came up with when buying a stock for quick profit due to a mismatch in prices in the market due to takeovers/selling of a subsidiary or associate). Apart from managing my own portfolio, I enjoy sharing my research with family and friends, seeking their opinions and views towards the stock.Reading Economics in London, I constantly keep up with the financial news in Singapore & Hong Kong. Despite my busy schedule, it has not stopped me from enjoying other aspects of life. I enjoy a variety of activities in whatever free time I may have – endurance running, marathons, traveling, fine dining, whiskey appreciation, fashion. Lastly, I enjoy meeting new people, discussing ideas and gaining new perspectives towards issues in the world.